How Strong Is This Bull?

By

Michael Santoli

Updated Nov. 22, 2004 12:01 a.m. ET

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CUP AN EAR AND LEAN IN CLOSE to hear the stock market's message, and it seems to be saying it wants to go higher. But ask how high and for how long, and the answer is likely to be far less soothing. The stock indexes went vertical for four weeks, a nearly unceasing surge that pushed up the Standard & Poor's 500 index 8%, to a 2004 high, leavened investors' spirits and stoked their hunger for risk. The prevailing mood has gone from fear of an election stalemate and agita over escalating oil prices to excitement and an urgency to buy into the rally.

It's always hazardous to guess the causes of any market move. But the market's lift coincided with an electoral sweep by Wall Street's preferred political party, a sharp retreat in petroleum prices and an improved employment report -- good enough proximate causes to keep the story moving.

Previously frustrated investors took it from there, rushing to participate and salvage what has been a tough year to turn a buck in stocks.

The suddenness of the spurt has left investors who didn't fully catch the turn desperate to know what happens in the next chapter. The market, of course, dispenses riches -- or takes them away -- in chunks, often when the consensus least expects it. Which leads to the urgent question: Is this rally the start of something more, making it worthwhile to buy into a market that's jumped 8% in 20 days?

On a very short-term basis, the answer appears to be yes, if only because bullish sentiment can be self-reinforcing for a while. And the idea that a fourth-quarter rally is under way has spread far and wide, supported by the remembrance of the year-end strength in five of the past six years (including 2003, whose rally culminated in a buying climax in late January of this year).

Well-credentialed market observers are inclined to give the upside momentum the benefit of the doubt for now. They point to its all-inclusive breadth, the swelling of trading volume, the breakout of the S&P and other measures from downtrends, stocks' refusal to succumb to any serious pullback and to the seasonal strength that tends to hold this time of year.

The analysts at Ned Davis Research and Lowry's Reports are among the tape diagnosticians who espouse this view, allowing -- as do even the most caffeinated bulls -- that the market is a bit overextended. The steepness of its climb and some currently frothy measures of investor enthusiasm helped set stocks up for Friday's abrupt 1% drop.

Market Vane's gauge of investor sentiment reached a 70% bullish reading last week, a level that tends to impede immediate upside and can foretell a correction. Similarly, the ratio of bearish put options traded to bullish calls reached an extreme low, another indication that greed is swamping fear.

If the handicappers are correct, however, any decline of 2% or 3% is likely to draw in new buyers, searching for market exposure to any sprint into the home stretch of the year.

It's tempting to strike a contrarian posture and proclaim that the party has gotten too crowded and is about to end, according to the venerable rule that the market tries to inflict maximum pain to the greatest number of investors. But it's probably more accurate to say that the crowds are joining the celebration at a fast clip, and there's still a bit more room before the festivities peak.

Sure, the small guy is starting to shovel cash into stock mutual funds, a common wrong-way indicator, with an estimated $5 billion entering equity funds last week, the most since April. But this is notoriously "slow" money and can continue for a while before a top is reached.

And consider that the strategists at a half-dozen of the largest brokerage firms -- including Merrill Lynch, Smith Barney, UBS and Bear Stearns -- are counseling caution and, even if nominally bullish, have index targets near or even below today's level. True, a couple of strategists have recently raised their recommended equity allocations slightly, but this hardly presents a picture of a cheerleading Wall Street.

What's more, tactically oriented hedge funds, as a group, were underexposed to stocks as the current rally began, according to statistical observations by Robin Carpenter of Carpenter Analytics in Hanover, N.H. These funds, like most investors, tend to follow market moves, and hedge-fund managers are still loading up on equity risk, he suggests.

The bulls, and even some agnostics, in the Market Prognostication Guild are issuing near-term upside projections that cluster in the 1200 to 1250 range on the S&P, 2% to 7% above current levels -- not glorious, but possibly worth playing for those who hate to sit out any fun.

If those targets are met soon, it could easily raise investor confidence to new heights. This would likely leave stocks that much more vulnerable to any intrusive bad news, and could present a pretty good selling opportunity just as the consensus breaks into "Happy Days Are Here Again."

Indeed, a few unwelcome developments could puncture the aura of good feelings now settling on Wall Street.

These include a bumpier path for corporate results following a peak in earnings growth in recent quarters; an upwelling of concern about the tumbling dollar, which was shrugged off by stock investors until Friday; and, of course, a resumption of the rising trend in oil prices.

It's noteworthy that the voracious buying of the past few weeks occurred in a period of relatively little corporate news, having begun just as third-quarter earnings reports were winding down. This placed fund flows, psychology, the oil market, politics and technical analysis in control.

This periodic dearth of corporate news will largely end within a couple of weeks, however, as companies assess their progress and give mid-quarter updates. This is otherwise known as preannouncement season, and the early indications are that this one could be less benign than other such periods since the market lows of March 2003.

The greatest risk to corporate fundamentals is a pronounced slowing of economic momentum that seemingly has not been filtered into analysts' earnings forecasts or been discounted in stock prices.

Last week the Conference Board's index of leading economic indicators fell more than expected, its fifth consecutive monthly drop. Other measures of economic velocity, such as the Institute for Supply Management's monthly manufacturing report, have also begun sagging, albeit from strong levels.

These are time-proven signals that forecasts of future earnings are likely to be pressured downward. The pattern of earnings-forecast revisions has turned more negative, as the chart on this page shows. That trend would appear even more worrisome if it weren't for the steady hikes in projected energy and materials earnings, as analysts race to catch up to commodity prices that have run ahead of most assumptions.

Smith Barney strategist Tobias Levkovich maintains a "leading profits indicator" that has a good record of predicting reported results. It is currently signaling that consensus fourth-quarter forecasts for 15% growth in S&P 500 company earnings are too optimistic.

For all of next year, profits are pegged for a 6% to 10% further gain, depending on whether you believe the somewhat sober top-down strategists or bubbly industry analysts. These numbers haven't stopped rising lately, placing them at risk of disappointment.

The aforementioned moderating economic trend is one thing, exacerbated by what economists agree will be a lagged impact of high oil prices. Then there's an incipient profit squeeze apparently developing as higher production costs -- including commodities -- are only partially being passed through to finished-goods prices.

Look, too, at the heady assumptions now embedded in those 2005 estimates, including hope for still-higher profit margins. Henry McVey, strategist at Morgan Stanley, calculates that 79% of the S&P 500 companies are now forecast to show improved profit margins next year, up from 68% this year. That would be a tough trick to pull off, given current historic highs in corporate profitability. It would be even tougher if companies quicken their hiring or if interest costs begin rising strongly.

And consider the dollar. The buck hit new lows against the euro last week and sits at levels last seen in 1995 against a trade-weighted basket of currencies. A weak dollar has been all but dismissed as irrelevant, or even embraced as a net positive, by the equity crowd lately.

Indeed, a lower dollar is being cited as a reason multinationals' earnings will get an extra boost next year. Another rationalization for buying stocks with those depreciating dollars is that the weakness isn't alarming unless it goes too far, too fast. What level and speed should cause worry isn't usually pinpointed.

Investors, for certain, have been conditioned to think this way. In the 20 months since stocks ramped off the pre-Iraq War lows, the dollar and stock prices have moved in almost precisely opposite directions, notes First Global Research. This inverse correlation is contrary to the predominant relationship between the two throughout history.

Edward Keon of Prudential Equity Group calculates that in the 30-odd years since currencies were floated, U.S. equity returns have been twice as strong in strong-dollar periods as in times of a weakening greenback. There are prominent instances of powerful stock rallies amid a softer dollar, but this pattern is not the norm.

Yes, it's true that there has long been an apocalyptic, bearish thesis out there that a dollar crisis would spur capital to flee U.S. markets, sending interest rates and inflation soaring and stocks into a collapse. And it hasn't paid to heed this case, with the crucial exception of several months beginning in the fall of 1987. But that doesn't mean that a further buckling of the dollar wouldn't result in stocks falling back to incorporate at least some probability that this chain reaction could arise.

Of course, there's no saying for sure that there will be any short-term follow-through for the rally, or that any such move would then falter. There are respectable, good-faith arguments by some bulls that a strong market may be blossoming to continue well into 2005.

One model for this upbeat case is the 1994-95 sequence, when a trading range amid Fed tightening and strong earnings gave way to a powerful and durable surge in 1995. And Ned Davis talks about the curious tendency of years ending in "5" to deliver strong returns.

However, this currently unfolding post-bubble market might be resistant to analogies involving strongly trending 20-year bull markets supported by continually lower interest rates and inflation. That being so, discerning the market's future requires examining some clues.

For one, the markets' continuing reaction to the dollar can indicate when to take some money off the table. Friday's simultaneous declines in the dollar and bond prices finally spooked stocks. If this trend proves more than a one-day blip, equity investors may want to rethink their bullish bets.

Other canaries in the coal mine? Oil would be an obvious one. Should the current retreat from $55 to $46 start looking like just a correction followed by a resumption of the uptrend, stocks would wobble.

The behavior of corporate insiders speaks volumes at market turning points. George Muzea, who tracks insider buying and selling, last week raised a warning flag that insider selling had jumped by 35% in November from October. He sees this activity rising to levels last seen early this year, and has turned more cautious on the market.

On the corporate fundamental front, sharp investors will be watching the market reaction to companies that issue profit warnings. Wednesday, for instance,
Applied Materials
' reduced profit outlook caused a fleeting decline in its shares, but then buyers quickly stepped in. The stock, and those of other semiconductor companies, ended up leading the market that day.

This is viewed as the behavior of a bullish tape. When stocks start taking bad news to heart, and investors look for chances to sell rather than embrace lower prices as invitations to buy, it may indicate a fatigued rally.

In other words: Trust -- for now -- in the potency of the rally. But constantly verify that it remains on solid footing.

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